Comparing LIFO Tax Benefits to Lower of Cost or Market Write-downs

Overview
Taxpayers must value inventories to determine cost of goods sold using one of the following two approaches:
- Cost: Actual price paid to acquire or produce the good. In most cases, this is approximated using one of the following cost flow assumptions:
  - First-in, first-out (FIFO): Oldest goods are assumed to be sold first, leaving the value of the most recently purchased goods on the balance sheet at year end. During periods of rising costs, FIFO creates the highest ending inventory value, lowest cost of goods sold and highest taxable income compared to all cost method alternatives.
  - Average cost: Treats all units in inventory as having the same average cost per unit during the period. During inflationary periods, the average cost method creates a lower ending inventory value and taxable income than FIFO, but higher than LIFO.
  - Last-in, first-out (LIFO): Oldest goods are assumed to be sold last. During inflationary periods, LIFO creates the lowest ending inventory value, highest cost of goods sold and lowest taxable income compared to all cost method alternatives.
- Lower of cost or market (LCM):
  - Inventory must be reported at the lower of cost (FIFO or average cost; LIFO can’t be used) or market value
  - Market: Uses a replacement cost approach constrained by a ceiling and a floor:
    - Replacement cost = The current cost to acquire or reproduce the same inventory item in its present condition (i.e., what it would cost today to replace it).
    - Ceiling = Net realizable value (NRV) — Estimated selling price in the ordinary course of business minus reasonably estimable costs of completion and disposal
    - Floor = NRV minus a normal profit margin
  - Market = Replacement cost, but not higher than the ceiling (NRV) and not lower than the floor (NRV − normal profit margin).
    - If replacement cost > NRV (ceiling) → Market = NRV
    - If replacement cost < NRV − normal profit margin (floor) → Market = floor
    - If floor ≤ replacement cost ≤ NRV → Market = replacement cost
LIFO Overview
- During periods of rising costs, LIFO transfers the inflationary component of goods on hand at year end from the balance sheet (inventory) to cost of goods sold (income) statement
- Purpose of using LIFO is to use rising inventory costs to create a tax benefit by increasing cost of goods sold and lowering taxable income, which creates less income taxes being paid compared to using FIFO or average cost
- LIFO reserve is the cumulative taxable income reduction from LIFO for all periods using the LIFO method & is the difference between FIFO & LIFO
- LIFO expense is the current year taxable income reduction from LIFO & is the difference between current & prior period’s LIFO reserve
LCM Write-down Overview
- Inventory is written down from cost to market value when the market value of a good is lower than its acquisition cost. Difference between cost and market value is transferred from the balance sheet to the income statement via cost of goods sold.
- Purpose of using LCM is to create a tax benefit from the market value of inventory falling below its cost
LIFO & LCM Pros and Cons
- LIFO
  - Pros
    - Creates a tax benefit every period there’s inflation & long-term tax benefits become exponentially higher than the LIFO election year benefits for companies with consistent and/or moderate/high inflation
    - Unlike LCM:
      
      LIFO recapture does not occur upon the sale or disposal of the goods that created the tax benefit
      
      LIFO can create an incremental tax benefit in periods where the current vs. prior year end inventory balance decreases
      
      LIFO does not rely on current vs. prior year end inventory balances to increase for the tax benefit to increase
    - LIFO ROI is extremely high & burden/complexity is extremely low when outsourcing calculation to LIFOPro
    - Very low IRS audit risk when outsourcing calculation to LIFOPro
  - Cons
    - Must value inventories at cost beginning year of LIFO adoption and ratably recapture prior LCM write-downs into income over a three-year period
    - Portion of tax benefit is recaptured into income during deflationary periods
    - Benefits may not outweigh the costs or administrative burden and complexity if suboptimal methods are used or calculation is performed internally
    - Prone to error and/or IRS audit risk when calculation is performed manually
- LCM
  - Pros
    - Creates a tax benefit whenever the market value of inventory is below cost
    - Incremental tax benefits can be obtained if either occurs:
      
      Current vs. prior year end inventory value increases & current vs. prior year end LCM reserve ratio does not decrease
      
      Current vs. prior year end LCM reserve ratio increases & current vs. prior year end inventory value does not decrease
    - Cons
      
      Portion of tax benefit is recaptured into income when the following occurs:
      
      Sale or disposal of any good valued below cost
      
      Current vs. prior year end inventory value decreases & current vs. prior year end LCM reserve ratio stays the same or decreases
      
      Current vs. prior year end LCM reserve ratio decreases & current vs. prior year end inventory value stays the same or decreases
      
      One or both of the following must occur for the cumulative tax benefit to grow:
      
      Current vs. prior year total inventory value increases and current vs. prior year LCM reserve ratio stays the same or does not decrease
      
      Current vs. prior year LCM reserve ratio increases & current vs. prior year total inventory value stays the same or does not decrease
      
      Increased administrative burden to support LCM reserve since IRS Regs. require concrete, contemporaneous evidence that market value is truly lower than cost
      
      Increases IRS audit risk if aggressive write-down procedures are used
LIFO & LCM Tax Benefit Comparisons
LIFO vs. LCM Write-down 5 Year Tax Benefit Comparisons: 2025 – 2029 Year Ends

Example #1

Assumptions:
- 5% LCM write-down rate
- Constant $20M FIFO balance
- Using 2021 -2025 Bureau of Labor Statistics Producer Price Index (BLS PPI) inflation for Machinery & equipment
Example #2

Assumptions:
- 5% LCM write-down rate
- Inflation-adjusted FIFO balances
- Using 2021 -2025 BLS PPI inflation for Machinery & equipment
Example #3

Assumptions:
- 10% LCM write-down rate
- Constant $20M FIFO balance
- Using 2021 -2025 BLS PPI inflation for Machinery & equipment
Example #4

Assumptions:
- 10% LCM write-down rate
- Inflation-adjusted FIFO balances
- Using 2021 -2025 BLS PPI inflation for Machinery & equipment
LIFO vs. LCM Write-down 20 Year Tax Benefit Comparisons: 2025 – 2044 Year Ends

Example #1

Assumptions
- 5% LCM write-down rate
- Constant $20M FIFO balance
- Using 2006 -2025 BLS PPI inflation for Machinery & equipment
Example #2

Assumptions
- 5% LCM write-down rate
- Inflation-adjusted FIFO balances
- 2006 -2025 BLS PPI inflation for Machinery & equipment
Example #3

Assumptions
- 10% LCM write-down rate
- Constant $20M FIFO balance
- Using 2006 -2025 BLS PPI inflation for Machinery & equipment
Example #4

Assumptions
- 10% LCM write-down rate
- Inflation-adjusted FIFO balances
- Using 2006 -2025 BLS PPI inflation for Machinery & equipment
Key Takeaways
- LIFO & LCM creates tax benefits in a similar fashion where a portion of inventory values are transferred from the balance sheet to cost of goods sold, thereby reducing taxable income
- LIFO is often considered a long-term tax savings tool because the incremental benefits become material
- LCM reserve is often considered a one-time or short-term tax savings tool because material incremental benefits aren’t possible without substantial increases in inventory values or employing more aggressive write-down procedures
- LIFO’s long-term tax benefits will be materially higher than LCM in many cases for the following reasons:
  - LIFO Tax benefits are based on the amount of cumulative inflation measured for all periods on LIFO, which will become materially higher than any LCM reserve ratio over long periods of time (many companies have > 100% cumulative inflation, which means LCM reserve will always be less beneficial than LIFO reserve once the cumulative inflation rate becomes > 100% since LCM reserve ratio can’t be > 100%)
  - LCM tax benefits are recaptured every time the written-down goods are sold or disposed of, whereas the LIFO tax benefits remain intact even when the goods that created the reserve are sold as long as those inventories are replaced
  - LIFO tax benefits can grow even when year over year inventory balances remain the same or are lower as long as there’s inflation, whereas the LCM reserve can not unless a significant increase in write-downs occur
- Companies with historically high inflation should explore adopting LIFO in 2025 even if they have preexisting LCM reserves because:
  - LIFO will create a bigger tax benefit than LCM in the election year alone if the 2025 inflation rate is greater than the 2025 LCM reserve ratio
  - LIFO will create a materially higher long-term tax benefit than LCM
Actionable Items

LIFOPro offers complimentary LIFO election benefit analysis for companies interested in exploring a potential LIFO adoption. Companies currently using the LCM method and writing down inventories can obtain a LIFO election benefit analysis that’s customized to their specific facts and circumstances to obtain accurate estimates of the short and long-term tax benefits of converting from LCM to LIFO. Contact Bob Richardson at LIFOPro today to learn more via email at robert@lifopro.com, by phone at 531-466-4275, or submit your benefit analysis request form online by clicking this link! LIFO election benefit analysis request

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Comparing LIFO Tax Benefits to Lower of Cost or Market Write-downs